The Impact of Spreads in Day Trading
Many traders refer to day trading as one of the most profitable trading stiles. Although I'm a day trader myself, I completely disagree with that statement. First of all the profitability of a trader does not depend on his trading stile, there are very profitable scalpers, swing and position traders. The profitability of a trader will depend on the trader's ability to find the stile that perfectly fits his/her psychology.
When it comes to day trading there are a lot of things to consider.
As we all know "you never get something for nothing", and if you are willing to become a day trader you should be well aware of that. In day trading spreads can make all the difference between a profitable trader and a looser. Most newbie's does not realize that spreads can have a big impact on their trading activity. This doesn't mean that currencies with large spreads are less interesting than currencies with smaller spreads… Although it seems a little bit confusing you will understand the logic behind it.
The spread to pip ratio:
Establishing a spread to pip ratio helps us to find which currency pairs are worth our money and which are not. To do this we need to convert the spread into a percentage of the average daily range of the currency we're willing to trade. Notice that average daily range change and so do spreads (spreads vary from broker to broker), the following calculation was made on October 28, 2010.
Note:In the percentage calculation the spread has been deducted from the average daily range, this is to reflect that retail customers cannot buy at the lowest bid price of the day shown on their charts. Accounting for the fact that picking the exact high and low is extremely unlikely, it's more realistic to calculate that trader has more less 80% of the available range available to them. These numbers paint a portrait that the spread is very significant.
EUR/USD, ADR: 166
Spread: 3
S/P Ratio: 166-3 = 163-10% = 146 3/146 = 2,05%
USD/JPY, ADR: 73
Spread: 3
S/P Ratio: 73-3 = 70-10%=63 3/63 = 4,76%
GBP/USD, ADR: 160
Spread: 4
S/P Ratio: 160-4 = 156-10% = 140 4/140 = 2,85%
USD/CAD, ADR: 112
Spread: 4
S/P Ratio: 112-4 = 108-10% = 97 4/97 = 4,12%
Traders need to be aware that the spread represents a significant portion of the average daily range in many pairs. The spread to pip ratio allows us to take only those pairs that offer better ratios for day traders. If you notice even though the USD/JPY offers lower spreads than the GBP/USD, the GBP/USD offer a way better spread to pip ratio making trading "cheaper" or less risky for day traders.
Questions and Answers
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